A Brief Historical Review of Behavioral Finance and Economics

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  • Dr. David Edward Marcinko MEd MBA CMP™

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James O. Prochaska PhD, Professor of Psychology and Director of the Cancer Prevention Research Center at the University of Rhode Island, developed the Trans-Theoretic Model of Behavior Change [TTM] which has been evolving since in 1977. Nominated as one of the five most influential authors in Psychology, by the Institute for Scientific Information and the American Psychological Society, Dr. Prochaska is author of more than 300 papers on behavior change for health promotion and disease prevention.

TTM Stages of Change

In his Trans-Theoretical Model, behavior change is a “process involving progress through a series of these stages:

  • Pre-Contemplation (Not Ready) – “People are not intending to take action in the foreseeable future, and can be unaware that their behavior is problematic”
  • Contemplation (Getting Ready) – “People are beginning to recognize that their behavior is problematic, and start to look at the pros and cons of their continued actions”
  • Preparation (Ready) – “People are intending to take action in the immediate future, and may begin taking small steps toward behavior change”
  • Action – “People have made specific overt modifications in changing their problem behavior or in acquiring new healthy behaviors”
  • Maintenance – “People have been able to sustain action for a while and are working to prevent relapse”
  • Termination – “Individuals have zero temptation and they are sure they will not return to their old unhealthy habit as a way of coping”

Relapse

In addition, researchers conceptualized “relapse” (recycling) which is not a stage in itself but rather the “return from Action or Maintenance to an earlier stage.” In medical care, these stages of behavior change have applicability to anti-hypertension and lipid lowering medication use, as well as depression prevention, weight control and smoking cessation.

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Psychology

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Uniting Psychology and Financial Behavior

More recently, validating the emerging alliance between psychology (human behavior) and finance (economics) are two Americans who won the Royal Swedish Academy of Science’s 2002 Nobel Memorial Prize in Economic Science. Their research was nothing short of an explanation for the idiosyncrasies incumbent in human financial decision-making outcomes.

Enter Kahneman and Smith

Daniel Kahneman, PhD, professor of psychology at Princeton University, and Vernon L. Smith, PhD, professor of economics at George Mason University in Fairfax, Va., shared the prize for work that provided insight on everything from stock market bubbles, to regulating utilities, and countless other economic activities. In several cases, the winners tried to explain apparent financial paradoxes.

For example, Professor Kahneman made the economically puzzling discovery that most of his subjects would make a 20-minute trip to buy a calculator for $10 instead of $15, but would not make the same trip to buy a jacket for $120 instead of $125, saving the same $5.

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in vitro and in-vivo Economics

Initially, in the 1960’s, Smith set out to demonstrate how economic theory worked in the laboratory (in vitro), while Kahneman was more interested in the ways economic theory mis-predicted people in real-life (in-vivo). He tested the limits of standard economic choice theory in predicting the actions of real people, and his work formalized laboratory techniques for studying economic decision making, with a focus on trading and bargaining.

Later, Smith and Kahneman together were among the first economists to make experimental data a cornerstone of academic output. Their studies included people playing games of cooperation and trust, and simulating different types of markets in a laboratory setting. Their theories assumed that individuals make decisions systematically, based on preferences and available information, in a way that changes little over time, or in different contexts.

University of Chicago

By the late 1970’s, Richard H. Thaler, PhD, an economist at the University of Chicago also began to perform behavioral experiments further suggesting irrational wrinkles in standard financial theory and behavior, enhancing the still embryonic but increasingly popular theories of Kahneman and Smith.

Laboratory

Other economists’ laboratory experiments used ideas about competitive interactions pioneered by game theorists like John Forbes Nash Jr., PhD, who shared the Nobel in 1994, as points of reference.

Assessment

But, Kahneman and Smith often concentrated on cases where people’s actions departed from the systematic, rational strategies that Nash envisioned. Psychologically, this was all a precursor to the informal concept of life or holistic financial planning. Kahneman was awarded the Medal of Freedom, by President Barack Obama, on November 20, 2013.

READ: Behavioral Economics and Psychology DEM

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MENTAL ACCOUNTING: What is it?

By Dr. David E. Marcinko MBA CMP®

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SPONSOR: http://www.CertifiedMedicalPlanning.org

DEFINITION: Mental accounting attempts to describe the process whereby people code, categorize and evaluate economic outcomes. The concept was first named by Richard Thaler. Mental accounting deals with the budgeting and categorization of expenditures. People budget money into mental accounts for expenses or expense categories

CITE: https://www.r2library.com/Resource/Title/0826102549

Mental Accounting is the act of bucketizing investments and then reviewing the performance of the individual buckets separately (e.g. investing at low savings rate while paying high credit card interest rates).

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Mental Accounting • Money is

Examples of mental accounting are: (1) matching costs to benefits (wanting to pay for vacation before taking it and getting paid for work after it was done, even though from perspective of time value of money the opposite should be preferred0, (2) aversion to debt (don’t like long-term debt for short-term benefit), (3) sunk-cost effect (illogically considering non-recoverable costs when making forward-going decisions).

In investing, treating buckets separately and ignoring interaction (correlations) induces people not to sell losers (even though they get tax benefits), prevent them from investing in the stock market because it is too risky in isolation (however much less so when looked at as part of the complete portfolio including other asset classes and labor income and occupied real estate), thus they “do not maximize the return for a given level of risk taken).

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Dr. Richard H. Thaler and Behavioral Economics

A behavioral scientist 2017 

By Rick Kahler MS CFP®

Human beings make most of our decisions—including financial ones—emotionally, not logically. Unfortunately, too much of the time, our emotions lead us into financial choices that aren’t good for our financial well-being. This is hardly news to financial planners or financial therapists. Nor is it a surprise to any parent who has ever struggled to teach kids how to manage money wisely.

Economic Model Assumptions

Yet many of the economic models and theories related to investing are based on assumptions that, when it comes to money, people act rationally and in their own best interests. There’s a wide gulf between the way economists assume people behave around money and the way people actually make money choices. This doesn’t encourage financial advisors to rely on what economists say about financial patterns, trends, and what to expect from markets or consumers.

2017 Nobel Prize in Economics

It’s significant, then, that the 2017 Nobel Prize in Economics went to Dr. Richard H. Thaler, professor of behavioral science and economics at the University of Chicago Booth School of Business. Dr. Thaler’s work has focused on the differences between logical economic assumptions and real-world human behavior. His research not only demonstrates that people behave emotionally when it comes to money; it also shows that in many ways our irrational economic behavior is predictable.

This predictability can help advisors and organizations find ways to encourage people to make financial decisions in their own better interest. The book Nudge, by Dr. Thaler and Cass R. Sunstein, describes some of those methods.

Example:

One example is making participation the default option for company retirement programs like 401(k)’s. Employees are free to opt out, of course, but they need to actively choose to do so.

A second example is the “Save More Tomorrow” plan, which offers employees the option of automatically increasing their savings whenever they receive raises in the future.

Both of these examples rely on a predictable behavior—human inertia. Most of us tend to postpone, ignore, or forget to take action even when that action would be good for us. So if a system is set up so not taking action leaves us with the choice that serves us better, we are “nudged” toward helping ourselves toward a healthier financial future.

Integration

As one of the pioneers in integrating the emotional aspect of money behavior into the practice of financial planning, I’ve long since come to understand that managing money is about much more than numbers. The world of investing may seem to be cold and calculating, but it’s actually driven by emotions. I’m familiar with the work of researchers who have demonstrated that some 90% of all financial decisions are made emotionally rather than logically.

I was pleased in 2002 when one of those researchers, psychologist Daniel Kahneman, won the Nobel prize in economics for his studies of human behavioral biases and systematic irrational behaviors. (That research was done jointly with psychologist Amos Tversky, who died in 1996.)

I’m even more pleased to see the economics Nobel prize go to a behavioral researcher for the second time. Maybe the realm of economics is beginning to integrate the untidy realities of human emotions into its theories. Eventually, this might lead to new economic models that take into account the emotions that shape people’s money decisions and the fact that money is one of the most emotionally charged aspects of our lives.

Assessment

Perhaps economists are beginning to appreciate the truth of the statement Dr. Thaler made at a news conference after his prize was announced. “In order to do good economics, you have to keep in mind that people are human.”

Conclusion

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Understanding Behavioral Finance and Economics

Historical Review

By: Dr. David Edward Marcinko; MBA, CMP™

By: Eugene Schmuckler; PhD, MBA, CTS

By: Dr. Kenneth H. Shubin-Stein, CFA

By: Richard B. Wagner; JD, CFP®

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Validating the emerging alliance between psychology (human behavior) and finance (economics) is the fact that two Americans won the Royal Swedish Academy of Science’s, 2002 Nobel Memorial Prize in Economic Science. Their research was nothing short of an explanation for the idiosyncrasies incumbent in human financial decision-making outcomes.

The Pioneers

Daniel Kahneman, PhD, professor of psychology at Princeton University, and Vernon L. Smith, PhD, professor of economics at George Mason University in Fairfax, Va., shared the prize for work that provided insight on everything from stock market bubbles, to regulating utilities, and countless other economic activities. In several cases, the winners tried to explain apparent financial paradoxes.

The Experiments

For example, Professor Kahneman made the economically puzzling discovery that most of his subjects would make a 20-minute trip to buy a calculator for $10 instead of $15, but would not make the same trip to buy a jacket for $120 instead of $125, saving the same $5.

Initially, in the 1960’s, Smith set out to demonstrate how economic theory worked in the laboratory (in vitro), while Kahneman was more interested in the ways economic theory mis-predicted people in real-life (in-vivo). He tested the limits of standard economic choice theory in predicting the actions of real people, and his work formalized laboratory techniques for studying economic decision making, with a focus on trading and bargaining.

Academe’

Later, Smith and Kahneman together were among the first economists to make experimental data a cornerstone of academic output. Their studies included people playing games of cooperation and trust, and simulating different types of markets in a laboratory setting. Their theories assumed that individuals make decisions systematically, based on preferences and available information, in a way that changes little over time, or in different contexts. By the late 1970’s, Richard H. Thaler, PhD, an economist at the University of Chicago also began to perform behavioral experiments further suggesting irrational wrinkles in standard financial theory and behavior, enhancing the still embryonic but increasingly popular theories of Kahneman and Smith.

Other Pioneers

Other economists’ laboratory experiments used ideas about competitive interactions pioneered by game theorists like John Forbes Nash Jr., PhD, who shared the Nobel in 1994, as points of reference. But, Kahneman and Smith often concentrated on cases where people’s actions depart from the systematic, rational strategies that Nash envisioned. Psychologically, this was all a precursor to the informal concept of life planning.

Enter the Financial Planners

Of course, comprehensive financial planners have always consulted with their clients regarding their goals and objectives, hopes and dreams, but typically from the point of view of money goals, rather than life ideals or business goals. The absence, or presence of biological and/or psychological reasons for them was never conceived, nor discussed. But, quantifying future subjective and objective goals, and doing a technical analysis of factors such as risk tolerance, age, insurance, tax, investing, retirement and estate planning needs, has certainly been the norm, especially for Certified Medical Planners (CMP).

Assessmentcmp-logo

Life planning and behavioral finance then, as proposed for physicians and integrated by the Institute of Medical Business Advisors (iMBA) is somewhat similar. Its uniqueness emanates from a holistic union of personal financial planning and medical practice management, solely for the healthcare space.  Unlike pure life planning, pure financial planning, or pure management theory, it is both a quantitative and qualitative “hard and soft” science. It has an ambitious economic, psychological and managerial niche value proposition never before proposed and codified, while still representing an evolving philosophy. Its’ zealous practitioners are called Certified Medical Planners (CMPs).

www.CertifiedMedicalPlanner.org

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